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33 Building block 2: Financial markets

step the financial institutions such as banks! They act as financial intermedi-

aries between lenders and borrowers. If there is more demand for long term

borrowing than potential supply, then banks offer lenders a slightly higher

interest rate in return for lending long term. A balance is struck and, as econ-

omists put it, markets are cleared.

The general picture is that companies like to borrow over relatively long

periods in order to achieve some certainty of repayment obligations as they

finance what they see as their long term growth. Lenders, however, see hav-

ing their money tied up for a long period as being somewhat more risky. So

lenders typically require a premium in return for lending long term. The exact

premium depends on market forces and it can even change sign in some situ-

ations.9 The evidence is that over a long period lending long term has attracted

a premium compared with lending short term.10 This is consistent with the

view that lenders normally require a premium for lending long term.

Interest rates and inflation

Inflation is the steady erosion of the purchasing power of a unit of currency

caused by increases in prices. One can think of interest rates as having two

components. One component concerns the desire of lenders to be compen-

sated for the effect of inflation. The second offers a so-called real return.

This seems quite an intuitive model. If it were to hold then the numbers

would work together like this:

(1 + inflation) Ã— (1 + real return) = (1 + nominal return )

So, for example, if the rate of inflation was 10% and the required real return

was 2% the nominal interest rate would be 12.2%. Note that because the

numbers are multiplied together rather than simply added, we finish up with

the extra 0.2% on the nominal interest rate.

This model goes a fair way towards explaining the historical trend in inter-

est rates.11 It is also intellectually appealing as one can feel comfortable with a

model that states that lenders are compensated for inflation. We do, however,

need to treat it with caution. Interest rates tend not to respond to inflation

For example, when short term interest rates are considered to be close to a peak it can appear cheaper

9

to lock in a lower rate for a long period. Only the passage of time will allow one to be absolutely sure

which was cheapest.

Over the period 1925â€“2000 the return on a dollar invested in 90 day US T bills was the equivalent of

10

3.8% pa. By contrast, the return on 20 year US government bonds averaged 5.3%.

Over the same 1925â€“2000 period, US inflation averaged 3.1%.

11

34 The five financial building blocks

changes in the simple way that the above model would suggest. There are

some fairly obvious reasons for this. For example, consider how investors do

not know what future inflation will be and that governments use the interest

rate as a lever to control inflation. So we should think of interest rates as hav-

ing a link to inflation but not being tied to it.12

Interest rates and exchange rates

Each currency will tend to have its own interest rate. So, for example, at the

beginning of May 2007 the short term interest rate in the USA was 5.23%

while the comparable rate in Japan was just 0.57%. Would borrowers be bet-

ter off borrowing in Japanese yen? This is a question that only the passage of

time can give a definitive answer to because the answer will depend on what

happens to exchange rates. So one can only know with hindsight whether or

not dollar or yen borrowing was cheaper.13

Financial markets, however, will provide an immediate indication of which

currency it is best to opt for. This is because these markets will allow curren-

cies to be exchanged not just immediately but also at any date in the future.

The answer that emerges from the markets will be that at any point in time it

should not matter which currency you borrow in since the forward exchange

rates will exactly compensate for interest rate differences. This is because if

the rates did not exactly balance, people would be able to make a profit for no

risk. Money would be invested in search of the profit and this would quickly

eliminate the opportunity. This effect is referred to as arbitrage.

The numbers work like this: suppose $1 will purchase 119.24 yen today;

and that 90 day interest rates are 5.23% for US dollars and 0.57% for yen. We

can compute the 90 day interest rate from the annual interest rate thus:

1 year interest rate = 5.23%

Hence quarter year interest rate14 = (1 + 0.0523)0.25 âˆ’ 1.

= 1.283%

Similarly, quarter year yen rate = 0.142%

The exception to this being for any debt that carries a formal link to inflation. Some government

12

borrowing is structured in this way; for example, index linked savings offered by the UK government

which pay interest at a rate equal to inflation plus a specified premium.

We would need to know the exchange rate on each occasion that an interest or principal repayment

13

was made.

Remember that because interest rates work through compound interest as opposed to simple interest

14

one cannot simply divide the annual interest rate by 4 to get to the quarterly interest rate. One has to

find 1 plus the interest rate raised to the power 0.25 and subtract 1.

35 Building block 2: Financial markets

So $1 today will become $1.01283 in 90 daysâ€™ time

Likewise, Â¥119.24 today will become Â¥119.4093 in 90 daysâ€™ time

These two amounts must be the same thanks to the principle of arbitrage.

Hence the forward exchange rate15 must be = 119.4093 Ã· 1.01283

= Â¥117.90/$

This means that a low interest rate is simply a signal that on the forward

exchange markets a currency will be strengthening. The low interest rate can

be expected to be offset by a higher cost of repaying the loan.

The answer to the question of which currency to borrow in comes from com-

mon sense rather than the financial markets. If a company wants to speculate

then by all means take a view on which currency will be the cheapest and bor-

row in that currency. However, if a company does want to speculate, why set

the amount of speculation by the amount of money that it wishes to borrow?

Borrowing should be thought of in the context of the way that it will be repaid.

So if borrowing will be invested with a view to generating a flow of US dol-

lars, then borrow in dollars. If the investment will yield yen, then borrow yen.

Hindsight may prove this to have been wrong, but no blame can be attached

and hindsight is equally likely to show that the decision was favourable.

How lenders minimise risk

Lenders will do everything they can to minimise risk up to the point where they

drive away a potential customer that they wish to satisfy. Lenders will be look-

ing for what they term security. Security means confirmation that interest and

principal will be paid on time. It can take many forms. The greater the security

the lower the risk on the loan and hence the lower the interest rate can be.

Clearly the amount of effort devoted to assessing creditworthiness will

be a function of the size of the loan. Major loans will be subject to large

what are called due diligence exercises. These will assess the risks associated

with a loan. This can be an eye-opening experience as banks focus on what

can go wrong with a particular situation. They do not just look at the most

likely outcome, they look at worst case scenarios. Banks will also have to

limit their own exposure to particular risks. They will, for example, probably

set a limit on the amount of money they lend in any particular country or

industry sector.

i.e. the exchange rate set today for a transaction that will take place in 90 daysâ€™ time.

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36 The five financial building blocks

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